Term Sheet Talking Points for Pipeline Companies

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AN INTRODUCTION TO THE TERMS OF AN INVESTMENT WHAT IS THE [FUND NAME]? 

The [FUND NAME] is [DESCRIPTION OF FUND]. The goal of the fund is to [INSERT INVESTMENT THESIS – ONE TO TWO SENTENCES].

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The companies the fund considers for investment should be upstanding members in their community – are trustworthy and treat their employees, suppliers and the surrounding community well.

WHAT IS [INV./FUND MANAGER NAME] ’S RELATIONSHIP TO THE [FUND NAME] 

[INV./FUND MANAGER NAME] manages the [FUND NAME] as [ENTITY RELATIONSHIP] and supports the fund’s investment activities.

We present opportunities to [FUND NAME]’s External Investment Committee for their consideration as potential investments. Our job is to work with you to outline the terms you are willing to offer to the investors so that they will want to invest in your company. We also perform an investigation of the investment opportunity (due diligence, discussed below) on behalf of the investors.

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If the investors agree to make the investment following due diligence, [INV./FUND MANAGER NAME] prepares the legal documents for the investment and presents them to you for your review. If/once everyone agrees, then we close the investment, and the investors wire the funds.

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Then, [INV./FUND MANAGER NAME] supports the fund’s investment through: i. Traditional investment management by serving on the Board of Directors, collecting quarterly management reports and monthly financial statements and representing the investors’ interests as we participate in (and/or control) key Company decisions. ii. Provide value creation and growth services to help the company refine and implement its growth strategy, connect to new markets, where applicable, and adopt international best practices: a. Good governance: building a gender-smart board which helps guide the company as it grows and supports management as it designs and implements growth strategies. b. Financial management: ensuring the accounting systems and internal controls are in place and at international standards so that your Company effectively tracks and manages cash flow to fund growth, avoids being a victim of fraud and realizes tax savings & efficiencies that may be available.

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c. Marketing: effective, gender-smart marketing strategies to grow sales through gender-sensitive collateral, access to new markets, new distribution channels and customer support and advertising. d. Strategic initiatives and coaching: helping design and advise the Board and management on other initiatives agreed upon by [INV./FUND MANAGER NAME] and the Company. For example, we may work with you to identify opportunities to launch new products, obtain certifications, and access new customers. iii. Separately, [INV./FUND MANAGER NAME] also works with Companies who are looking for additional financing to grow. Often, an early-stage investment triggers growth that requires additional working capital or financing for equipment. We do this work under a separate agreement which outlines the services we offer and how we will be paid. To be clear, this agreement applies to separate, later efforts by the Company to raise funds after [FUND NAME]’s investment.

HOW DOES THE [FUND NAME] PAY [INV./FUND MANAGER NAME] FOR ITS SUPPORT? 

[INV./FUND MANAGER NAME] receives a portion of the return the investors receive (carried interest) over and above the return of their principal investment (hurdle rate).

Thus, the [FUND NAME] does not pay [INV./FUND MANAGER NAME] until they see a return on their investment. This means [INV./FUND MANAGER NAME] wins when the Company and the investors win. So, we are going to work at least as hard as you to make the Company a success and to get our investors an attractive return. Everyone wins in this scenario.

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In addition, [INV./FUND MANAGER NAME] may hold a portion of the shares that the Company offers to the [FUND NAME]. If the amount of work [INV./FUND MANAGER NAME] anticipates we will be doing to support the Company’s growth is significant, these shares provide some compensation to [INV./FUND MANAGER NAME] for our work.

ARE THE TERMS THE [FUND NAME] IS WILLING TO ACCEPT SET OR ARE THEY NEGOTIABLE? 

There are certain terms the [FUND NAME] is looking for that are not negotiable – for example, representation on your company’s Board is typically required. Other terms are negotiable. For these terms, you can present something for the [FUND NAME] to consider, and they can either accept or reject them or counter with an alternative.

WHAT IS THE PROCESS FOR COMING TO TERMS ON THE INVESTMENT? 

INITIAL MEETING: Like this one where we present the key terms and roughly what the Company would need to offer in order for the [FUND NAME] to consider looking at an investment in the Company. If we believe the Company is willing to offer terms (note – companies offer terms to attract investors) that are in line with what the [FUND NAME] is looking for, then we will present it to the External Investment Committee.

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SCREENING MEETING: The External Investment Committee (IC) meets to evaluate several opportunities. If your Company makes it to this stage, the External IC members will consider the opportunity you are presenting and whether it looks attractive, considering the following: i.

is management ethical and trustworthy,

ii.

is management qualified to grow the company and are they open to working with [INV./FUND MANAGER NAME] and making hires as necessary to implement changes to realize growth,

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does the business and the market look good (for example, does the company have a competitive advantage in the market, are the margins attractive, etc.), and

iv.

are the terms the Company offers to the investor attractive and in line with the member’s investment criteria.

TERM SHEET NEGOTIATION: This may happen before or after the Screening Meeting. i.

The term sheet is a document that outlines, in an abbreviated way, the parties’ expectations about the terms on which they plan to proceed with an investment, IF the investors agree to move forward after due diligence is complete. The term sheet is an agreement between the fund and the Company’s shareholders and management that, unless they discover something alarming during due diligence that cause them to question the basic attractiveness of the investment opportunity, they will proceed with an investment on the terms outlined in the term sheet. These terms are abbreviated and will be outlined in more detail in legal documents before closing.

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DUE DILIGENCE: [INV./FUND MANAGER NAME] coordinates an investigation of the company, its products and processes, its management, the market, the supply chain, the investment strategy, laws and regulations that might impact the company and the investors’ ability to recover their principal and realize a positive return. If something comes up during due diligence that might cause concern for [INV./FUND MANAGER NAME] or the investors, [INV./FUND MANAGER NAME] will present that to the Company and, where applicable, discuss ways to address the issue.

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LEGAL DOCUMENTS: If the [INV./FUND MANAGER NAME] is satisfied with the results of the due diligence process, [INV./FUND MANAGER NAME] will prepare legal documents and present them to the Company’s shareholders. If/once the parties agree on the documents, they sign them, close the deal, obtain necessary approvals and coordinate the transfer of funds.

WHAT ARE KEY TERMS I SHOULD EXPECT TO OFFER TO ATTRACT AN INVESTMENT? 

Company shares / equity: i.

In most cases, investors will expect to join you as shareholders of the

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company. This aligns their interests with yours in seeing the company grow, since they benefit with you when the company realizes net profit. a. As equity investors, the [FUND NAME], and [INV./FUND MANAGER NAME], on the fund’s behalf, are with you as mentors and coaches to help you grow. Equity investors realize a return on net profit, rather than collecting a portion of revenue, as would be the case with debt.

This provides the company more leeway to cover operational expenses and to grow. Giving the investors equity means you are not required to provide collateral directly for the financing they offer your company as you would if the investors provided a loan. The investors are in the same situation as you, the existing shareholders, in that the protection you have for your investment is that, if something terrible happens, you and the investors would share in the proceeds from a liquidation of the company after any lenders collect what is owed them.

This, again, is risky, so equity holders require a higher return than lenders. ii.

The amount of equity offered must be sufficient, so that investors are able to realize an attractive return on their investment, given the risks outlined above.

[INV./FUND MANAGER NAME] and the [FUND NAME] expect to hold enough of the Company’s equity so that we are viewed as important stakeholders.

Companies we have worked with typically give up [RANGE] if they are an existing company and [RANGE] if they are a new company / early stage. You will need to be comfortable offering something similar.

iii.

How is the percentage of equity determined? a. First, the company is valued using discounted cash flow. Think of this as the present value of the sum of the company’s future profit.1 b. Example: Let’s say in 2021, the company expects to earn $100K in net profit. Each year after that, the company expects to see a 20% growth in net profit. The value of the company would be determined by calculating the present value of future net profit ($100K + $120K + $144K + $173K + 207K + $249K). The present value of the future net profit is not just the sum of those profits. It is the discounted sum of those profits, determined by discounting each future payment by a rate that represents the risk that that payment will not be realized. These risks may be related to the company (e.g., the size of the company, the investor’s belief in management’s ability to grow as planned, or the likelihood the company will default on payments owed), market dynamics (e.g., the competitiveness of the market), economic factors (e.g., inflation) or geopolitical (e.g., free trade agreements, political stability, civil unrest). The greater the risk means a lower valuation.

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Projected net profit is adjusted for certain non-cash expenses, like depreciation.

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c. In the example above, the company would be valued at $760K if a 25% discount rate is used and the company’s net profit is assumed to grow at 20%. d. Second, calculate the % that the investor’s planned investment represents of this value. In the example above, a $250K investment would equal 32.8% of the company’s value. The amount of equity the investors would expect would be 32.8% of the company. iv.

NOTES: a. The value of the company is NOT based on its current assets (including goodwill) or even on past sales. What you and the investors care about is the expected future return you will realize on your investments of time and money into the Company. These returns will be realized in the form of dividends or capital gains when your shares are purchased. b. Just because the company’s valuation now does not factor in the value of company assets (like buildings, equipment, lease rights, or goodwill), does not mean the investors do not expect the company to hold onto these assets. The company will need these assets to grow and to generate the returns that the investors and you expect. So, the company will have to hold these assets on its books and have clear rights to use them. c. You may be tempted to offer investors as high a valuation as possible.

There are advantages to doing this in the near term, but this can come back to hurt your Company because investors may decide not to invest in your Company because you have offered them too little equity. If the investors chose to invest at the higher valuation, this may mean you will have more difficulty raising funds later when you are talking with other investors later. These investors may be unwilling to invest when you need them to because you have set the valuation of your company so high that it is not attractive for them to make the investment.

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Shareholder loan: i.

Investors may choose to do a portion of their investment as a low-interest shareholder loan. There may be multiple reasons for this, including (a) earlier recovery of part of the principal amount of their investment, (b) tax savings for the company on interest payments (if it is allowed to deduct the interest payment as an expense) and (c) to address certain regulations in [COUNTRY] that are not clear and present a risk that the [RELEANT TAX AUTHORITY] will tax the company for amounts invested as principal in [COUNTRY] PLCs.

ii.

In [COUNTRY], local law limits the interest shareholders may charge on interest to very low rates. As a result, investors cannot expect to realize an attractive return on their investment from the shareholder loan. For instance,

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the investors might realize a return of say 3-5%, rather than the 25% or so return they expect for an unsecured investment in a company in [COUNTRY].

This means the investors need to rely more on the returns they realize from holding equity in the company for their investment return.2 

Buyback of the investors’ shares: i.

The investors are investing with the company because they see an opportunity to earn an attractive return over a defined period of time. They will not want their money tied up with the Company forever. This means they will expect to have the right to sell their shares for a return that reflects the benefit they have provided to the Company for the use of their money and the risk they have taken on in providing that money. Investors will expect to have the option to sell their shares to the Company, management or a third-party investor in year 6 following the investment. The price will be at a price determined now. It is a low price so unless the Company is not doing well the investors are less likely to exercise this option, but they require that they are given this option so that they have at least one pre-agreed-to path for exiting their investment.

ii.

A couple notes about how the buyback works: a. The right is triggered typically at the end of year 6 following the investment or if there is a change of control or a third party acquires most of the Company (unless the Investors consented to the change of control or acquisition) b. The Company and the existing shareholders are expected to pay the agreed upon price for the investors shares BUT only from retained earnings (or dividends received). We expect the Company or existing shareholders to begin saving for this redemption in Year 5. This means either the Company holds back part of the dividend it would otherwise pay out to you, or you set aside dividends you receive from the Company in year 5. This saving is not required, though, unless the Investors notify the Company by the end of year 5 that they plan to exercise their redemption right. A reason for this saving requirement is that it provides a faster way for you to buy out the Investors.

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The buyback amount is paid in installments if the Company cannot afford to pay it outright in year 6. Installments equal (roughly) available cash after certain necessary expenditures in fixed and working capital reserves. The redemption amount is paid before dividends.

Example: In the above example, say the investors invested $100K of the $250K as a shareholder loan at 5%. The company may be able to deduct that 5% interest payment as an expense on their taxes and avoid the risk that [RELEVANT TAX AUTHORITY] taxes the Company for the receipt of that $100K. Because the investors are only realizing 5% interest on that loan, though, and it is unsecured, the investors will need to realize additional return elsewhere. So, they will expect equity of around 25% for the remaining $150K, even though if they invested just $150K (without the shareholder loan) that would buy them only 20% equity. This way, they recover their target return of around 25% across their total investment.

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Shared decision making: i.

As shareholders in your Company, equity investors will join you in making certain key decisions. We anticipate that this is part of the reason why you are asking [INV./FUND MANAGER NAME] to join you as an investor. We offer our experience running companies and helping other companies grow, our networks and access to new customers and partners and strategic consulting.

We will expect to have a say over certain key strategic decisions, the company’s budget, major partnerships, etc. The goal being that we work together to build a company into a leader in its market.

ii.

The investors also expect to have a say over certain key decisions that could significantly impact their shares, such as when you sell the company or certain major assets, how much you pay management, when you take out additional debt, etc.

iii.

[INV./FUND MANAGER NAME], as a representative of the [FUND NAME], will hold at least [NUMBER] seat(s) on the Company’s board. Also, so that the investors and [INV./FUND MANAGER NAME] remain informed of what is happening with the Company, you will need to provide quarterly management reports and financial statements.

Liquidation rights: i.

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As mentioned above, the investors will expect rights to a pro rata (in proportion to the percentage of the Company’s shares they hold) percentage of proceeds from the sale of the Company’s assets if the Company is shut down for some reason. For this reason, the Company will have to hold clear rights to all of the valuable assets of the company, unless otherwise agreed upon with the investors. (Plus, the investors will expect that the Company owns or has acceptable lease terms for the equipment, building, and other assets it needs for its operations.)

This is not an exhaustive list – but rather some of the key terms that you will need to be comfortable offering to investors for them to consider an investment in your company.

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